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The Useless Quantity Theory of Money

“If the government creates money all it’ll do is cause inflation and we’ll all suffer.” This is one of the deadliest lies we’ve been told for the last 40 years. For centuries, philosophers and economists thought that any increase in money would always increase prices. John Maynard Keynes pretty much set the record straight on that about 80 some years ago. But the idea has been resurrected in the last few decades and is now mainstream again. It’s this rationale that conservatives use to justify destroying social programs, budget cuts, and the basis for the current debt “ceiling” discussions in Washington. What makes the idea so insidious is that it makes sense on the surface. With most things, the more of something there is, the less it’s worth. But unlike most things, money has no intrinsic value. That makes it fundamentally different. Below I will show you the modern re-emergence of this theory and why it is bullshit.

Money has no value until it is spent. What that means is that only at the time of purchase does it have an effect on inflation. For instance whether a single dollar bill is spent 4 times, or 4 dollar bills are spent once, the effect is the same. To give an example of what I mean, let’s look at two scenarios:

One day, a cold man buys a coat from a coat shop for a dollar. Now let’s say the owner immediately gives that dollar to one of his employees as their salary for the day. The employee then turns around and buys a coat as well. The shop owner then takes that dollar and buys lunch at a cafe. The owner of the cafe then takes that dollar to the shop and buys a coat. Finally, the shop owner takes the dollar to the owner of a billboard and buys advertising. The billboard owner then takes that dollar and buys a coat with it. On the way home the shop owner buys a book with his dollar from the bookstore.

In the second scenario. Let’s change the order. The cold man, the cafe owner, the employee, and the billboard owner all come in to the coat shop in the morning and buy a coat for a dollar. At the end of the day, the shop owner takes those 4$ and pays his employee’s salary of 1$, buys dinner at the cafe, buys his billboard ad, and gets his book. That’s 8$ worth of activity from 4 single dollar bills.

In both scenarios, the end result is the same. 4 people have coats, the shop owner has payed his one employee, gotten a meal, has advertising, and bought a book. That’s 8$ worth of activity from a single dollar bill in the first scenario, and 8$ worth of activity from 4 single dollar bills in the second scenario. How is that possible? Doesn’t more money always mean higher prices? In short, No. The rate that money is spent also has an impact on prices. As far as prices and demand is concerned, a single dollar being spent 10 times has the same effect as 10$ being spent once.

This is something that economists have know for a long time. They even have a fancy, glazed-eye inducing formula to represent it. They eventually boil the formula down to this. MV=PQ. In their own convoluted way, what economists are trying to say is that, All existing Money(M) multiplied by the average number of times it is spent(V) is equal(=) to the amount of goods in the economy(Q) * the average price of those goods(P).

For example, if in a small town there are only 10 physical dollars(M) and each dollar is spent 3 times(V) then that means there was 30$ worth of activity. So if there were only 3 things bought(Q) in that village(say a toaster, a coat, and a lighter), then their average price would have to be 10$(P). If there were 6 things bought, then the average price would have to be 5$. M times V must always equal P times Q. M * V = P * Q. This equation is non-controversial among all economists. It is logical and self-evident.

This finally brings me to the lie we’ve been told for decades. Some guy, decades ago, took that equation MV = PQ and said something to the effect, “well, if you ‘assume’ that the velocity of money is constant and that the economy cannot(or will not) increase the amount of goods, then any increase in the money supply will only serve to increase prices”. Algebraically, it makes perfect sense. If you assume that ‘V’ and ‘Q’ are constant, then making M bigger would HAVE to make P larger. Thus was born the Quantity Theory of Money. You probably see the problem with this already. ‘V’ and ‘Q’ are most certainly not constant! (Funnily enough, that same guy still managed towin a Nobel prize in economics.)

‘V’ or the velocity of money is not constant. That’s why during the start of a recession the federal government can run huge budget deficits and still see ‘P’ or prices go down. When people feel insecure about the economy, households save money in case of a layoff, and businesses don’t risk new investments. The rate money is spent goes down and in the case of 2008, completely eclipsed the increase in the money supply created by budget deficits.

The other assumption that ‘Q’ is constant is also bullshit. An increase in money or spending rate can make the number of goods in the economy(Q) go up instead of prices. Think of a car factory being inundated with requests for more parts. Instead of increasing prices they could add a third shift. As long as there are enough unemployed workers to hire for the third shift, the increase of MV will affect quantity(Q) and not prices(P). Q would increase instead of P as long as the ability to increase supply exists. If there aren’t enough workers (or some other constraint), then the factory would have to raise prices. This situation would exist when there is almost no one who is unemployed to be hired for the third shift. You might be asking “why wouldn’t the factory just increase prices and reap all those profits?” The answer is that if the factory just increased prices they would be susceptible to some other factory adding a third shift and keeping their prices low – or as economists like to put it, “firms increase quantity before prices to maintain their marketshare”.

Now you should be able to see the absurdity about worrying about rising prices when unemployment is so high. High unemployment means that ‘Q’ isn’t at it’s highest. Therefore increasing ‘M’ via federal budget deficits will have very negligible effects on ‘P’. Instead new jobs will be created and we can enjoy the increased goods without increased prices. Only when the economy is maxed out will budget deficits start increasing prices. It is at that point that we can start worrying about budget deficits and debt “ceilings”. Worrying about them before that happens is stupid.

I’ve tried to show in the most logical way I am capable, of why we shouldn’t fear increasing the amount of money at times like this. Now that you’ve seen the basis for the “Quantity Theory of Money” and the assumptions that it relies on, I hope you can see why it’s bullshit. While it may be “technically” true if it’s assumptions are true, the assumptions are rarely, if ever true.

Availability of money increases when economies slow, as available money is not tied up in inventory or transactions. As it is fungible, it may be sitting in some other instrument, but it just doesn’t dissapear. Thus money is cheaper during times when economies don’t grow or become sluggish, and inflation islow. If there is too much available money for the amount of activity in the economy, and velocity or the number of transactions also slow, the formula is further upset. Prices of goods inevitably rise, and thus inflation occurs. The only way to reverse the trend is to increase the size of the economy or increase the number of transactions.
Freespending liberal politicians continue to labor under the misconception that economies always grow. Thus they see their duty to increase the number of “government transactions” or spending by the government. This does not increase the size of the economy at all because government always takes more out of the economy to support costly programs than they really cost (their overhead) while that same government puts nothing back into the economy to make it grow, Government is only a sunk expense, never an investment, as progressive demagouges continue to deny the reality.
Japan serves as a good example as to the failure of Keynesian theory. Decades of no growth, decades of needless infrastructure spending to spur growth, and assumption of massive amounts of debts have led to a crippling position moving forward. The “savers” in Japan are the big losers. They cannot pull the money back out of the subways stations, airports, and glorious infrastructure projects where it could be put to use in other ventures that would add to growth. Liberal politicians in Japan are happy that their country suffered a major catastrophy as it once again gives them the opportunity to spend even greater sums on more infrastructure projects, a continuation of their failed Keynesian philosphy.

http://www.ourdime.us/ Dustin

Kevin, Thanks for reading. I highly suggest you read another of my articles, How money is created. Once reading it you’ll see how your why your first paragraph is wrong. What you described would only work in a world where money is actually limited. Say, a gold standard, which the U.S. and world hasn’t been on since the Nixon Shock of 1971 that took us off of the gold standard.. However, even in a gold standard “money” in the form of credit can disappear. In our modern system, all money is created as a debt. When a loan is payed off, the financial asset disappears. If the loan is defaulted on, the financial asset disappears.

As for your second paragraph about Japan you have several political facts mixed up. Until 2009, Japan has had a conservative government(The American definition of “Conservative”) for several decades.

Talking about the intricacies of Japan’s problems would require several articles. I’ll try to summarize. First of all, the conservative government tried to react to their crises mostly through Monetarist means. The central bank slashed interest rates to near 0%. The political body even tried to “get banks lending again” – another Monetarist approach. When those didn’t work, they attempted some limited demand management(classic Keynesian) approach by creating some limited public works. That brought GDP growth back from the brink, but then they stopped, and their central bank raised interest rates out of fear of inflation(Another Monetarist idea).

Japan’s problems are that they thought their recession was a typical “over investment” recession. Those happen. However, like the U.S. now, they are experiencing a “balance sheet” recession. Their government ran a surplus and left it’s citizens, firms, and banks in deep debt. They were way over leveraged, and once the recession hit and they all tried to start paying off the debt instead of take on more, the recession got deeper and deeper. To this day, most Japanese firms and households are net saves. Part of the reason the government has so much debt.

I get the feeling that your analysis of Japan’s lost decade is very politically motivated. So i’ll offer a more “conservative” approach to fixing Japan’s problem. If Japan’s government wanted to save themselves by applying Modern Monetary Theory, spending is not the only way. Being a conservative government , they could let their infrastructure rot and never create their bullet trains, they could’ve just drastically cut taxes. The important thing is to run budget deficits. So long as they didn’t offset their tax cuts with spending cuts,they would stimulated demand and get themselves out of their current funk.

Why not advocate just cutting everyone a check? Make it time valued so it must be spent quick. Is government is better equipped to make decisions than the masses of the market? Unless your new money is in the hands of the consumer first, then the feel good car factory example doesn’t work.

Your scenario is one of many mathematical possibilities. Therein lies the problem. If total goods are falling and money is increasing then you have a real scary situation. If the economy has become disconnected from the price signals of the people the chances of it being oversupplied with goods of limited utility increases.

Consider a situation where massive well connected firms within the economy has been over subsidized for long periods of time. The most successful firms are the ones closest to government. Moreover, the cost of money is less the closer the firm is to government. The market has been disconnected from the price signals of the people and the only portion of “total goods” that is increasing are government preferred goods (corn, electric vehicles). For simplicity’s sake total goods = useful goods + useless goods. Now the government is increasing the supply of useless goods and also increasing the supply of money. Goods are going up and money is going up. Your right, Milton wrong.

So as total money and useless crap go up there is additional price pressure on useful goods, as the useless stuff suffers from lack of demand. Meanwhile the productive capacity of the economy is diverted into useless crap as opposed to being continually refined by free acting agents trying to better their lives.

http://www.ourdime.us/ Dustin

Why not advocate just cutting everyone a check?

I think that would be a fine idea… as long as it isn’t offset by other spending cuts or increased taxes.

Make it time valued so it must be spent quick.

I would not be in favor of this.

Is government is better equipped to make decisions than the masses of the market? Unless your new money is in the hands of the consumer first, then the feel good car factory example doesn’t work.

You are arguing against something I never said.

If total goods are falling and money is increasing then you have a real scary situation.

And if pigs had wings, they could fly. Total goods decreasing, and yet total money increasing? No point in worrying about something that has never happened.

Consider a situation where massive well connected firms within the economy has been over subsidized for long periods of time…
*snip*
…Now the government is increasing the supply of useless goods and also increasing the supply of money.

Again, you are arguing against something I never stated. No economic theory can prevent a government from spending money stupidly, but no matter how dumb or how smartly it is spent, a budget deficit is needed. I already agreed with you that cutting everyone a check would be a good solution. There is no need to make knee-jerk anti-government argument against something that I never stated.

In many of these instances total goods were falling as the money supply increased. In others, government was stupidly spending money on “useless” goods while “useful” good production was falling. My main point is it’s fatal conceit for you or any “board” of smart people to predict the proper supply of money or to properly direct the new money into productive sectors of the economy without distorting the natural price signals of the people and resulting in a misallocation of resources.

“No economic theory can prevent a government from spending money stupidly, but no matter how dumb or how smartly it is spent, a budget deficit is needed.”

Government spending stupidly can be greatly mitigated by a gold standard. However, our current system allows for basically unlimited government spending via a deficit or monetization of debt. By contrast, the Byzantine Empire persisted for nearly 1,000 years under a gold standard.

http://www.ourdime.us/ Dustin

Ah Jeez, you got me. I responded much too quickly and ended up saying something stupid. So please let me fix my comments to what I was trying to say and please forgive the stupidity of what I did say. I said “Total goods decreasing, and total money increasing” never happens. Of course that has happened – that was dumb of me to say. What I was trying to say was “total goods decreasing, and inflation accelerating” never happened. The money supply is often expanding, either through private lending or public spending. That was much less dumb to suggest.

Unfortunately, for me, I have to admit I might have to still admit even my original statement is incorrect. As you point out, in cases of hyperinflation that statement may not hold true. I would not care to wager what happens one way or the other in cases of hyperinflation. When hyperinflation hits it usually means the people have rejected the currency, or some other external economic catastrophe has occurred. In both those case, all bets are off.

So, if you’ll allow me. I’d like to further amend my original statement to: Outside of cases of hyperinflation, Total goods decreasing, and inflation accelerating” has never happened.

Now, as for your “main” point:

My main point is it’s fatal conceit for you or any “board” of smart people to predict the proper supply of money or to properly direct the new money into productive sectors of the economy without distorting the natural price signals of the people and resulting in a misallocation of resources.

Again, you’re arguing with things I never suggested. I feel like you’re trying to stick me into a “monetarist” or “old keynesian” box. I assure you, I will not fit in either of those.

Government spending stupidly can be greatly mitigated by a gold standard.

Not really, the only thing it does is set an artificial budget limitation. In theory, it might reduce spending(although, in the past it hasn’t really), but what money is spent could still be spent stupidly. The only real budget limitation is the goods the economy can produce that it currently isn’t. If the government asks for more than that, then accelerating inflation results.

The most unfortunate part of a gold standard is that it can really reduce the ability to maintain full employment. Budget deficits are needed from time to time. I know you don’t believe that demand management is ever needed, and I believe that it is often needed in a monetized economy. I think you’ll agree, this is really our point of departure and this bickering over the “quantity theory of money” is just a proxy battle over this disagreement.

the Byzantine Empire persisted for nearly 1,000 years under a gold standard.

By that logic, we should also bring back Eunuchs. Or, also by that logic, perhaps we should follow the Native Americans and be on a “wampum standard”.

Praxeologist

I think the point of departure may be a bit more fundamental.

Goods are not homogeneous, so the limitation based on goods the economy can produce is a chimera. Assuming the purpose of goods is to to meet the needs, wants and desires of the people, to ascertain the near infinite heterogeneous nature of total goods would require knowing the personal judgments and dispositions of all individuals acting within an economy. Therefore, its pure arrogance to assume that it is knowable that x amount of spending,stimulus or rate increase will result in the furtherance of the ultimate needs, wants and desires of free acting agents better than those agents themselves. A sound money system does not suffer from this fallacy as it requires limited to no monetary authority making such decisions. Short of that, a totally transparent type of system such as an algorithm, or just cutting everybody a check would be better. But thats pie in the sky, as such control is used inevitably as a pretext for continued expansion of government or a perpetuation of the interests of a select group.

In practice what has been the result of allowing basically unlimited government spending? We subsidize the hell out of corn, and now half of the children born to our generation (assuming were roughly the same age) are predicted to be diabetic during childhood. (I’m sure there is some government favored industry ready to capitalize on the diabetic children market already.) Endless finance of an endless war? Made the firms that were too large to fail larger?

Meanwhile, there is endless licensing, rules, regulations, piece of shit public schools, food stamps, tobacco taxes, health codes, food codes, tax codes, wage laws, drug laws, health laws endlessly bearing down on the poor. It is literally impossible for a person born of low income to become an entrepreneur in a legal purely legit way…. unless they’re employed by the government in some manner. The winners have written the rules so most of the rest of us are fucked. Try to start a business with limited income and you’ll find this out very fast.

What is it the government should be spending money on? Who’s your chosen lottery winner? Which department should expand, or how about a new one? Whats the next zombie to prop up to later collapse?

http://www.ourdime.us/ Dustin

To be clear, when you say “sound money”, you mean “gold”, correct?

No, I’m pretty sure our point of departure was what I stated. I believe that demand management is needed to stave off an output gap, you don’t. Your explanation of “require knowing the personal judgments etc etc…” is only an argument on that. What I can tell you is that once an economy is monetized, recessions happen, no matter what the money is based on. But, like I said, getting far beyond just the merits of “The Quantity Theory of Money”.

Short of that, a totally transparent type of system such as an algorithm, or just cutting everybody a check would be better.

Not a necessarily bad idea for fair, transparent demand management.

As for the rest, it’s just pure personal politics. My only question to you is, let’s say federal spending was artificially limited. What makes you think it would spend money only on the things you think it should, and not cut it to continue corn subsidies and “endless wars”?

http://myidclub.com/archives/64 Leonarda Dean

I was looking for that a long time. Can you give me a list of your references? Thanks. We all will wait for your new posts.